Distress in china’s real estate sector: whose default is it?
Heightened regulatory scrutiny in China dominated headlines for most of 2021, forcing investors to navigate tumultuous waters and question the implications of investing in the world’s second-largest economy. News surrounding the possible collapse of China Evergrande Group, once China’s largest real estate developer, shined a spotlight on the property sector, a significant component of the Chinese economy. China represents over 30% of the MSCI Emerging Markets Index1, so understanding the impact of regulatory changes on the real estate sector, along with how our investment process and models prevented the extreme losses realized in the sector, is critical for emerging markets investors.
The opening of China’s economy in the late 1970s ushered in an era of unprecedented growth, which allowed millions to be lifted out of poverty. Sharply increasing demand for urban housing, driven by a quickly growing middle class, sparked concerns about overheated real estate prices. Decades of government policies to balance the objective of increased urbanization while controlling soaring property values have spurred countless debates around the probability of a bubble in China’s real estate sector.
Growth is central to China’s plans for a prosperous society. Although the government’s goal was to shift the economy toward consumption-led growth, in part to deal with its shrinking workforce, growth during the last 50 years came predominantly from fiscal stimulus, leading debt-to-GDP levels to rise steadily. During this time, the government enacted a number of policy changes to spur economic expansion, including reducing requirements for multiple mortgage down payments. Increased credit access for developers and ease in securing residential mortgages were also introduced to speed up urbanization goals.
Policy easing helped China Evergrande Group, established in 1996, become one of the largest property developers in China. The company amassed astronomical debt developing properties to accommodate the growing middle class, although some of its investments were more unorthodox (e.g. a soccer stadium, which the government has taken over). In an effort to ameliorate extraordinarily high debt levels in the real estate sector, regulators introduced the “three red lines” policy in mid-2020. The policy outlined balance sheet stipulations developers had to meet in order to take on more debt.